A crisis not wasted

Jun 10, 2010 11:50 UTC

White House Chief of Staff Rahm Emanuel famously said crises shouldn’t be wasted. Lucky for U.S. financial markets, the 80s savings and loan debacle wasn’t. Reforms passed in response meant U.S. regulators were better prepared than their European rivals to process the current crop of bank failures.

For months Spain has struggled to resolve troubled savings banks, resorting to a haphazard merger process. It’s not clear such combinations will bring stability, even if they can be completed. The collapse/bailout of CajaSur caused markets much consternation. Even now, Spain’s other savings banks are racing to merge before the June 30 expiration of the country’s temporary bailout law.

Meanwhile America’s FDIC closes a handful of institutions every Friday night without incident. The difference is strong rules to resolve collapsing banks, rules we got thanks to the S&L crisis.

During that episode the Federal Reserve routinely lent to insolvent institutions, funds that often ended up in the pockets of insiders and bank creditors, compounding taxpayer losses.

Such walking dead banks were christened “zombies” by Boston College Professor Edward Kane. Kane, along with other academics George Kaufman and George Bentson, helped lead reform efforts to stop Fed lending to insolvents and to empower bank regulators to seize them proactively, reducing costs. As a result, FDIC was well-prepared for the latest wave of bank failures. Over two hundred have been quickly and quietly closed since 2008.

Not having suffered similarly instructive bank crises in their own past, European nations were caught flat-footed coming into this one. Besides Spain’s troubles with savings banks, the UK was unprepared for Northern Rock’s collapse in 2007. Only afterward did the British adopt a special resolution regime modeled on the American one.

True, the European banking system is more concentrated than the American one. Most of FDIC’s takedowns are of small, systemically meaningless banks. But its regulatory toolkit proved adequate to shutter WaMu, a giant bank with $307 billion of assets, at no cost to anyone besides the bank’s shareholders and creditors. And since 2008, it has closed 53 banks with more than $1 billion of assets, 10 of which had assets over $10 billion.

The U.S. system is far from perfect. The original sin of the post-S&L rules was a “systemic risk exemption” granted regulators to lend to zombies determined too big to fail. That exemption was trotted out multiple times during the crisis, most infamously for FDIC’s debt guarantee program, which gave financials like Citi, Goldman, GE and many others explicit government backing.

The real problem, facing Americans and Europeans alike, is that the very biggest banks remain too large and complex to resolve. American regulators hope this problem will be solved with new “resolution authority” contained in legislation.

Still, most bank failures are, thankfully, remarkably boring affairs as insured depositor accounts are seamlessly transferred to healthy institutions or paid out. It goes to show that good regulation can indeed come out of crisis.

COMMENT

Those weak banks might not ever get large enough to cause a financial stir if the FDIC made some of their ratings public. After all we have to bare our financial souls to borrow a dime, why shouldn’t banks have to prove their solvency to their customers? Then consumers would shun weak banks before they got too big.

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Lunchtime Links 6-9

Jun 9, 2010 14:10 UTC

The blog prophet of euro zone doom (Thomas, NYT)

Hoenig wants a rate increase (Kelleher/Gillam, Reuters) He won’t get it. The Fed has trapped itself. The only way to keep the economy “growing,” is to pump ever more copious amounts of credit into it. If we’re not willing to put up with any recession whatsoever in order to pay-down/write-off debt, well, then, eventually we become Greece. Even central banks that print the currency in which their debt is payable can’t defy gravity forever. The Japanese have tried for the better part of a generation….hasn’t worked so well….

Here’s a chart to make the above point:

Fed trapped

All TruPSed up (Alloway, Alphaville) Great, clear post from Tracy. Bank capital is still just about the most important issue in financial markets; this is the latest fight…

CHART: Mortgage purchase applications keep dropping despite low rates (Culp, Reuters) There will be no sharp recovery for housing. Too much shadow inventory and too little demand. Rates may even decline to new lows on more flight to safety buying of U.S. government paper, but don’t expect housing to get much of a boost.

Legacy for one billionaire, death but no taxes (Kocieniewski, NYT) No clever tax dodge here, Duncan just happened to die in 2010, a year when the estate tax dropped to 0%.

Bubble Watch: $35k per night hotel room (Nassauer, WSJ) NY’s gilded age is surely returning post Lehman…

Whole new level of American laziness (reddit)

Weight-lifter goes for gold, projectile vomits on judge and passes out (windycitizen) He apparently went for a third attempt after this. Why? Just why?

Superman

COMMENT

Rolfe — You are wrong about Japan.

The Japanese have have not sincerely tried to print, c’mon. Japan was massively levered and they never printed anything on the scale of the delevering. Instead they engaged in 20 years of Keynesian nonsense, with the government levering up, and are back where they started, only far older and with the debt on the public balance sheet.

You went to the U. of Chicago, you should know the answer! A real Friedmanite solution in Japan would have been to let the private sector delever but *do not* lever up the public sector with senseless and *unproductive* Keynesian spending. Instead, stand back and if deflation starts to go too far, just provide raw money printing to the people as needed to avoid letting deflation get out of control.

The private sector wants to operate with less leverage these days. This would be steeply deflationary because money multipliers would shrink. The solution must be to increase the base money supply in the least distortionary way possible. Rather than have the government borrow and spend on unproductive things, it should just get printed cash into the hands of its citizens. They will be able to pay off debt and the financial sector will heal naturally.

Japan has solved nothing in 20(!!!!) years because there just wasn’t a way to pay back the huge debt. It was bad debt, unservicable in relation to the money supply. The debt needed to be destroyed one of two ways: Either
(1) Stand back and let everyone go bankrupt in a deflationary collapse. This is the classical solution. You could then reorganize and not have wasted 20 years. This is brief, terrible and politically untenable.
-or-
(2) Print new base money immediately. This will seemingly be inflationary but in reality you are only pulling the money supply along to keep up with the asset inflation that has *already* occurred. Some debt may be destroyed by inflation but it is much less disruptive if it is at low levels.

Bill Gross pushed this very well in March 2009.
http://www.pimco.com/LeftNav/Featured+Ma rket+Commentary/IO/2009/Investment+Outlo ok+Bill+Gross+March+2009+Hairy+Lips+Sink +Ships.htm

Gross said in order to deal with the debt load, we need a “return to nominal GDP growth levels of 5-6%, the majority of which might actually come in the form of higher prices as opposed to increased production. This Faustian bargain would be acceptable if only to stabilize what now appears to be an even more dangerous deflationary debt liquidation.”

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Evening Links 6-7

Jun 7, 2010 21:53 UTC

Betting on the bad guys (Adams, WSJ) From the cartoonist behind Dilbert.

Consumer credit increases slightly in April (CR) Credit excluding mortgage debt is back on the rise…ever so slowly…and probably not for long…

Fed paper: Effective homeownership rate much lower than official rate (NY Fed) The official rate from the Census Bureau was 67.2% at the end of ’09. But back out those with negative equity, and the rate is 5.6% lower. And that’s using optimistic house price indices from OFHEO and FHFA. Using Case-Shiller, the homeownership gap is much worse.

BofA settles Countrywide overbilling scams for $108 million (Wyatt, NYT) As mortgage bonds increasingly went bad, Countrywide’s servicing business had to find ways to squeeze out profits. This was a particularly slimy way to do that…

New iPhone presentation crashes on, you guessed it, network trouble (Gizmodo) The crowd laughs it off. iPhone users everywhere unsurprised.

Dow falls below “Flash Crash” low

20 years of growth in Shanghai (skyscrapercity)

Parenting Fail (Abrams, Asylum)

Funny: Calvin and Hobbes on capitalism (imgur)

COMMENT

uncompetitive? noncompetitive?

sigh… english, I hate thee.

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Bank Failure Friday

Jun 5, 2010 04:01 UTC

Three failures tonight…including one in Nebraska with assets/deposits over $2 bilsky.

#79

—Failed bank: First National Bank, Rosedale MS
—Acquiring bank: The Jefferson Bank, Fayette MS
—Vitals: assets of $60.4 million deposits of $63.5 million
—Estimated DIF damage: $12.6 million

#80

—Failed bank: Arcola Homestead Savings Bank, Arcola IL
—Acquiring bank: None. Insured deposits paid out.
—Vitals: assets of $17.0 million deposits of $18.1 million
—Estimated DIF damage: $3.2 million

#81

—Failed bank: TierOne Bank, Lincoln NE
—Acquiring bank: Great Western Bank, Sioux Falls SD
—Vitals: assets of $2.8 billion deposits of $2.2 billion
—Estimated DIF damage: $297.8 million

Lunchtime Links 6-4

Jun 4, 2010 14:15 UTC

CHART: Census responsible for almost all job growth (Culp, Reuters) 411k census jobs added in May. 431k total jobs added.

Not for the forint-hearted (Alloway, Alphaville) There could be some political posturing behind these comments from Hungarian officials — who suggest, in effect, that Hungary is the next Greece. Still pretty unsettling.

Euro hits 4-year low on mistranslated French comment (Reuters)

CBO issues Fed-flattering propaganda (Naked Capitalism)

Global bank capital pact advances (Enrich/Paletta, WSJ) Article says the new Basel accords could require $1.2 trillion of additional capital and liquidity. Reminds me of Greenspan’s comment that U.S. banks should carry 15% TCE, which would force them to raise similarly huge sums. While everyone agrees banks need more capital, regulators aren’t actually going to force them to raise it while they’re trying to follow their faux dual mandate of not just keeping banks safe, but also encouraging them to “lend more to get the economy going.” The two goals directly conflict.

Happiness may come with age, study says (Bakalar, NYT)

Keanu Reaves gives £50 million of his Matrix residuals to movie’s behind-the-sceners (HelloMag)

Big Picture captures birds caught by the oil spill (Globe)

COMMENT

The Euro was worth about .87 just a few years ago. Why should it surprise anyone that it is headed back that way? The survival of the EU is itself in doubt.

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Free ride ending for U.S. wireless bandwidth hogs

Jun 2, 2010 21:52 UTC

By Rolfe Winkler

Bandwidth hogs are losing a big trough. AT&T on Wednesday became the first major U.S. mobile service provider to shift from an all-you-can-eat model to tiered pricing for email and Internet access.

The decision is likely to cut into sales at first, but could improve the company’s long-run profitability and end nightmarish network problems. Customers look to be the early winners, while conditioning them to pay for usage should provide a longer-term victory for carriers.

AT&T is shrewdly pricing the plans to keep customers happy. Most should actually see bills decline. Users who consume less than 200 megabytes a month, 65 percent of them according to AT&T, could pay $15 instead of the current $30 for the unlimited plan. Considering how unhappy many customers are with the service, widespread price increases wouldn’t have gone down well.

Even though the heaviest smartphone users will pay more, AT&T’s average revenue per user will probably dip. The company expects little impact on 2010 sales, but JPMorgan estimates service revenue could fall as much as 5 percent on an annualized basis.

Any hit to short-run revenue will be a price worth paying if customers can be convinced to pay for consumption. As things stand, the capital expenditure required to support iPhone users means they may be worth nothing to AT&T, according to research firm Sanford Bernstein, although the company disagrees.

Better network quality requires investment, and consumers are now being pushed to pay. Despite the competition, prices should rise over time, especially as bandwidth usage continues to swell. AT&T’s decision appears to rely on rivals also forcing those clogging the networks to shoulder most of the burden of improving the mobile plumbing. It seems a good bet, for if other providers don’t follow suit, they’re apt to attract the feasters who cause dropped calls and slow downloads for everyone.

Evening links 6-2

Jun 2, 2010 21:35 UTC

Quote of the Day: Absolving Moody’s for failing to see the housing bubble, Warren Buffett employed the “who-could’ve-known” defense when he told the Financial Crisis Inquiry Commission today that “rising prices are a narcotic” that corrupt the critical thinking of rational people. To that Chairman Phil Angelides responded that rising prices may be “a narcotic, but don’t we expect ratings agencies to avoid it? You don’t want [the credit] police trading crack.

BofA admits foreclosure can be appealing (CR) The bank acknowledges the obvious, that if you’re not concerned about a hit to your credit rating–or losing your house–you can live rent free for more than a year waiting for the repo guy to get to you. On a related note…

Owners stop paying mortgages, and stop fretting (Streitfeld, NYT)

CDS spreads for oil companies blow out (Alphaville) This matches the huge drop in the share prices of companies that are attached to the spewing Macondo well in the Gulf. If the spill can’t be contained, will the liability?

Buffett expects “terrible problem” for municipal debt (Frye/Selway, Bloomberg) The Oracle did offer some wisdom about municipal issuers…

“People become immune to coffee boost,” experts say (Roberts, BBC)

Visualizing the BP oil disaster (ifitwasmyhome)

Lego printer uses world’s cheapest ink cartridge…LOL!

American Idol creator gambles on an encore

May 31, 2010 14:48 UTC

By Rolfe Winkler

Pop impresario Simon Fuller is ready for an encore. He wants his hit TV show American Idol back. This time it’s shaping up to be a duet, as Fuller has another deep pocket to join his own. The empire is bigger too, with image rights to Elvis Presley and Muhammad Ali added to the mix. But Fuller may yet come to regret a return to the same stage.

With a fortune built on the back of the Spice Girls, Fuller sold his TV talent show to CKX in 2005 for $174 million. He’s now ready to fork over $600 million, with one of Britain’s wealthiest bankers, Roger Jenkins, to buy back the whole company, according to the Wall Street Journal. That works out to about $6.50 a share.

It would be a nice premium to Thursday’s closing price of $4.32, but it’s little more than the $6 the shares traded at in late March when the company confirmed sale talks with then-boss Robert F.X. Sillerman, who resigned to launch his own bid. The market seemed skeptical, knocking the shares 30 percent below the $6 he was believed to be offering. It’s still not clear if a bid ever materialized.

Fuller’s offer may appear to shortchange CKX investors. But valuing the company at a modest seven times estimated 2010 EBITDA may not be so bad given the ratings for the American Idol finale sank to 2002 levels and its star, Simon Cowell, just left to launch a competing singing show.

Fuller and Jenkins likely view CKX as a cornerstone for a budding entertainment empire, having put together a $1 billion fund for acquisitions. Still, it seems like they’re paying a full price for the privilege.

The Idol worship follows another entertainment mogul’s return to his roots. Haim Saban just reacquired the Power Rangers kids franchise that started his road to riches. Like Saban, Fuller probably feels he knows his baby best, and is well suited to keep it strong. That may be true. But at the premium Fuller is willing to pay, current CKX investors should be happy to make this a swan song.

Bank failure Friday

May 28, 2010 23:44 UTC

Happy long weekend everyone!

#74

–Failed bank: Bank of Florida – Southeast
–Acquiring bank: EverBank, Jacksonville FL
–Vitals: assets of $595.3 million, deposits of $531.7 million
–Estimated DIF damage:$71.4 million

#75

–Failed bank: Bank of Florida – Southwest
–Acquiring bank: EverBank, Jacksonville FL
–Vitals: assets of $640.9 million and deposits of $559.9
–Estimated DIF damage: $91.3 million

#76

–Failed bank: Bank of Florida – Tampa Bay
–Acquiring bank: EverBank, Jacksonville FL
–Vitals: assets of $245.2 million and deposits of $224.0 million
–Estimated DIF damage: $40.3 million

#77

–Failed bank: Granite Community Bank, N.A., Granite Bay CA
–Acquiring bank: Tri Counties Bank, Chico CA
–Vitals: assets of $102.9 million and deposits of $94.2 million
–Estimated DIF damage: $17.3 million

#78

–Failed bank: Sun West Bank, Las Vegas NV
–Acquiring bank: City National Bank, Los Angeles CA
–Vitals: assets of $360.7 million and deposits of $353.9 million
–Estimated DIF damage: $96.7 million

Morning Links 5-28

May 28, 2010 13:17 UTC

For some people, CDOs aren’t a four-letter word (Goldstein, Reuters) Great sleuthing from Matt. He tells the story of Donald Puglisi, who continues to make major bank as the rubber-stamp independent director for toxic CDOs.

Wall Street’s War (Taibbi, Rolling Stone)

FASB’s mark-to-mayhem (Alloway, Alphaville)

“Housing production credit crisis”? (CR) There is still a huge overhang of shadow inventory. 7.3 mln homes in foreclosure or in default. Not all of the defaulted ones will end up being repossessed by the bank, but the point is that there’s not shortage of inventory. We don’t need to stimulate supply…

PIC: Oil spill operations overview (OilDrum, ht CB) A fish’s-eye view. Plus, another new BP logo.

Drilling for certainty (Brooks, NYT)

The web shatters focus, rewires brains (Carr, Wired) “Even as the Internet grants us easy access to vast amounts of information, it is turning us into shallower thinkers, literally changing the structure of our brain.”

Critics destroy “Sex and the City 2″ (Rust, AtlanticWire) Don’t count on box office figures to suffer…

Buffett subpoenaed to testify before Crisis Commission (Fortune, ht Ed Harrison)

VIDEO: 8 month old reacts to ear implants that let him hear for the first time (YouTube) Priceless.


COMMENT

Linking to the neo-cons’ greatest water carrier re: the Gulf disaster is regrettable. As anyone who has read the WSJ account of the accident two days ago can instantly surmise, there were corners cut and steps ignored that were standard operating procedure for any ORDINARY oil platform of the last thirty years:
http://online.wsj.com/article/SB10001424 052748704026204575266560930780190.html?m od=WSJ_hps_LEADNewsCollection

Let Brooks regurgitate Taleb’s ‘Fooled by Randomness’ to the conservative demographic of the NYT who would never read the book. Your readers deserve better-MUCH better.

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Buffett warned Congress about derivatives…

May 27, 2010 14:46 UTC

…in 1982.

Fast forward 28 years and the Oracle dispatched lieutenants to Washington to fight sensible derivatives reforms that would have made it more expensive to maintain his $63 billion portfolio of them. Luckily the White House beat back the “Berkshire provision.”

In the 1982 letter obtained by Forbes,  Buffett waxed philosophic on the dangers of derivatives. His analysis was remarkably prescient. The kind of wisdom one might expect from him today. But as has been clearly demonstrated over the past two years, Buffett is less concerned with sound public policy than with protecting his own interests.

His investment in Goldman was an effort to profit from TARP; he benefited more than anyone from FDIC’s explicit guarantee of bank debt while arguing that such guarantees are unfair; he mocked Treasury’s stress test, which forced banks to raise much needed capital; he opposed Obama’s sensible bank tax, which would charge TBTF banks for the implicit government guarantee they receive; and he was first to propose a public-private partnership to leverage public money to overpay for banks’ toxic assets.

The bottom line is that Buffett is more hard-nosed capitalist than financial straight-shooter. His advocacy of higher taxes for the rich tends to fool media hagiographers into believing he’s willing to sacrifice his interests or those of his investors for the public good. But he’s simply not the unbiased arbiter of sound financial policy that many still believe him to be…

(ht Scott Frew)

COMMENT

It is worth noting that even WB’s seemingly populist and magnanimous stance on taxing the rich is not entirely what it seems.

All of his jawboning has been on increasing income taxes for high-earners. But his wealth has almost as much to do with tax avoidance (because his income is unrealized) as as with investment returns. The overwhelming majority of WB’s wealth has compounded untaxed for 50 or 60 years. I have no problem with that generally, for why should someone pay taxes on unrealized gains? But lets not think he would be harmed by the taxes he advocates.

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Lunchtime Links 5-26

May 26, 2010 18:28 UTC

Fed’s next move could be reduced rate on dollar-euro swaps (Hilsenrath, WSJ) The Fed is charging so much that it discourages European central banks from drawing on the swap lines. That’s good. If we’re dealing with a liquidity problem, as opposed to a solvency problem, the idea is to lend freely, but at penalty rates, not market or below-market rates…

Geithner to urge European bank stress tests (Lodge, CNBC) Sound advice. The stress test is Geithner’s biggest achievement as Treasury Secretary. It can be argued that banks still have too little capital, but at least they’ve got a lot more than they did. Geithner deserves credit for forcing them to do so. Euro banks could benefit greatly by going through the same exercise.

Thirst for knowledge may be opium craving (eurekalert) “Neuroscientists have proposed a simple explanation for the pleasure of grasping a new concept: The brain is getting its fix.”

The net worth of U.S. presidents in today’s dollars (Atlantic) Washington was worth over $500 million…

House Republicans, meet the world wide web (Milibank, WaPo)

Some spat-upon NYC bus-drivers take months off (AP) “The indignity is considered an assault under the drivers’ union contract. That entitles them to take a paid break.”

Oscar….just…he just…jumped man. It was horrible! (imgur)

COMMENT

“Sound advice. The stress test is Geithner’s biggest achievement as Treasury Secretary. It can be argued that banks still have too little capital, but at least they’ve got a lot more than they did.”

Yet at the same time people are blaming the higher capital requirements for causing the banks to retract lending at the worst possible time…

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Lunchtime Links 5-25

May 25, 2010 15:50 UTC

Question of the day: Why is there still nearly $3 trillion parked in money market mutual funds? They yield nothing, they aren’t FDIC guaranteed, they CAN break the buck, and they’re less liquid than bank accounts. Thinking back to autumn ’08, when credit markets start to seize up, cold hard cash stuffed in your mattress looks more appealing. You can withdraw cash from a bank account, not so a money market fund. Not that I’m recommending that, it’s just that if you’re not getting any benefit by holding the money market fund, why bother? (401k money may be stuck, but others aren’t…)

Does Buffett deserve his outsider’s rep? (NY Mag, ht Ed Harrison) This blog’s view is no, of course. Good piece, though it misses many of the other public policy issues Buffett has been on the wrong side of. PPIP, the stress test, the bank levy. Also, his bank holdings survived thanks to TLGP.

Case-Shiller: house prices “weakening” (CR) Mortgage rates may be plumbing their lows, thanks to flight-to-safety buying of Treasuries, and that may cause demand to pick up a bit. But so much was pulled forward by the expiration of the homebuyer’s tax credit on May 1st, you gotta think prices are headed back down. Especially considering that there are 7.3 million homes that are in foreclosure or delinquent. That’s a lot of shadow inventory.

InterOil smashed again after lame press release (BizInsider) IOC has been a favorite short for hedgies for a long time. Looks like it’s finally working out for them.

Four Spanish savings banks make initial merger pact (NYT) This came after the Bank of Spain took control of CajaSur. Marc Chandler at Brown Brothers Harriman offers this thought today: “The European debt crisis is not simply a Greek phenomenon.  Spain is the focus now.  Spain (sovereign and private) owes foreign investors roughly $1.1 trillion.  In comparison, Greece’s external debt is closer to $236 bln.”

Germany eyes wider short-selling ban (Graham/Aloisi, Reuters) Populism that will fail to stabilize markets. If Europeans truly want to squeeze the shorts, they should announce dramatic budget cuts that solve their underlying solvency problem.

LIBOR reverse cliff-diving (Reuters)

Hubble finds a star eating a planet (NASA) This is an artist’s rendering, not a pic from space. Still, pretty cool.

Useless cat (imgur) Click on image to enlarge.

Comic…

6obcF

COMMENT

I would like to point out my passion for your kind-heartedness supporting men who really want guidance on this one matter. Your very own commitment to getting the message around had become extraordinarily beneficial and have in most cases helped women like me to get to their ambitions. Your own invaluable instruction signifies much to me and substantially more to my fellow workers. Many thanks; from all of us.

Sunday reading 5-23

May 23, 2010 15:51 UTC

Must Read — Padded pensions add to NY’s fiscal woes (Walsh/Schoenfeld, NYT) Putting in overtime for a utility, and counting that as hours worked for the police force in order to pad pension payouts.

Must Read 2Why Legendary Investor more worried than ever (Zweig, WSJ) I spent 5 hours in the “cage” at the NY public library reading their only copy of Seth Klarman’s book, Margin of Safety, back in 2007. Copies of the out-of-print book are so rare/valuable, they’re no longer allowed to circulate. This piece is full of great pearls of wisdom from one of America’s most successful and least well-known investors.

A billionaire goes all-in on gold (Pleven/Cui, WSJ) Gold is more than a bit frothy to go all-in, IMHO.

For Millenials, traditional markers of adulthood prove elusive (Rubin, Chicago Trib) Interesting piece. It’s mostly about how new college grads just can’t find jobs. Going back to Klarman, by propping up the economy Japan-style, we’re setting ourselves up for years of stagnation. So what are all these kids going to do with themselves? In Japan, the lack of economic dynamism may have been a crucial factor in the emergence of the grass-eating boys. Will something similar happen here?

U.S. drops criminal probe of AIG execs, including Joe Cassano (Plumb, Reuters) Cassano ran AIG Financial Products, using his corporate parent’s high credit rating to absorb much of the credit risk Wall Street was manufacturing during the bubble.

VIDEO – Cashing in on the end of the world (Reuters)

The 21st century orchestra? (Neil deGrasse Tyson)

Freedom = jumping off a swing (reddit)

Kung-Fu Bear…

Bank failure Friday + teachable moment for investors

May 22, 2010 01:40 UTC

Just one small bank shuttered tonight.

#73

–Failed bank: Pinehurst Bank, St. Paul MN
–Acquiring bank: Coulee Bank, La Crosse WI
–Vitals: assets of $61.2 million, deposits of $58.3 million
–Estimated DIF damage: $6.0 million

As a reminder, FDIC still has $63 billion of cash on the balance sheet despite the fact that it showed a negative balance of $20.7 million at the end of Q1.

How’s that? Assets = Liabilities + Equity.

Cash assessments collected from banks are assets on the left side of the balance sheet, but how they’re accounted for on the right side can be complex. Normally FDIC counts these as its own capital, as equity, also called the DIF’s “balance.” But because these were regular assessments collected up front, they’re counted as deferred revenue — a liability — instead of as equity.

So FDIC has more than enough cash raised from banks to pay for bank failures on its radar. The issue is banks that aren’t on its radar, i.e. the TBTFers. Those guys have raised a fair amount of capital, but if any one goes down, it would quickly overwhelm the DIF, forcing FDIC to borrow from Treasury.

TEACHABLE MOMENT…

For those that don’t understand deferred revenue, it’s a simple accounting idea that’s important to master because it’s the key to finding the best investments, the kind that made Warren Buffett rich.

In a nutshell, deferred revenue is revenue that’s been received, but not yet earned. For example, a newspaper business might charge for a yearly subscription up front, but it has to deliver the product over the following 12 months.

The idea behind your basic income statement is to match revenue with expenses incurred to generate it. So if I get paid up front to deliver 12 months worth of newspapers, then I recognize the revenue over 12 months even though I got all the cash on day 1.

On the asset side of the balance sheet, cash is cash. But on the right side, instead of as equity, it’s counted as deferred revenue, a liability I have to work down by delivering my product over the specified period of the contract with my customer.

So why is having lots of deferred revenue the characteristic of a good business? It reduces risk. Wouldn’t you rather get paid up front to deliver a product or service than to put all the work in first? For instance, retailers have to invest in inventory to stock their shelves for the Xmas season. But maybe the retailer screws up, stocking his shelves with tickle-me-Elmos and slap bracelets when kids today are looking for a Blu-Ray PS3 or the latest Justin Bieber album. Retailers can quickly go out of business this way, investing in inventory that doesn’t sell.

There’s also the problem of receivables collection. Powerful customers can demand I deliver my product today, and then not pay me for 30 to 90 days. Sometimes, they may not pay me at all and I have to write off what they owe me as uncollectable.

These risks are removed if the equation is flipped and I get paid before I deliver my product.

Warren Buffett’s path to riches was paved by the ultimate deferred revenue business: insurance. He gets paid premiums up front and only incurs expenses as claims are filed. In the meantime, he gets to hold on to the premiums (called “the float”), which he can invest in the stock market. And if no claims are filed, then he gets to keep the cash collected. Pretty cool.

So, when looking to invest, always pay attention to how cash flows into and out of a business.

In particular, calculate “capital employed” on the balance sheet. There are a few different ways to do it, but the way I was taught:

Capital employed = (receivables + inventories + prepaid assets + net fixed assets) – (accounts payable + accrued expenses + deferred revenue)

If this figure is consistently negative over time, it’s a sign of a good business.

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